Debt Ceiling Woes and Why You Shouldn't Worry

There's a fight in Washington over the debt ceiling. You'll hear more about it in the coming weeks as we near the debt ceiling. It's very possible that we see some market volatility stemming from the impasse. All that said, I'm not worried and I expect we will see a resolution without a default. Here's why.

First, let's look at the bigger picture. Thinking back to civics class, you know that Congress controls spending. They do this by appropriating money through the budget and by utilizing Continuing Resolutions when they can't get a budget passed in time. Where do they get the money for the budget? Taxes and borrowing. Taxes make up the biggest portion of revenue, but they don't cover all our spending. The difference between revenue and spending is the deficit (not the National Debt, although it contributes to it).

To put the numbers in perspective, for 2019 the government spent $4.4 Trillion but only took in $3.5 Trillion in revenue. The $984 Billion difference was funded through borrowing, borrowing which is then added to the national debt. That borrowing consists of bond sales by the US Treasury. Treasury bonds are essentially IOU's from the US Government. When you hear people say that China owns our debt, they're really saying that China owns Treasury bonds. This goes back to my piece last week about the US Dollar's position as reserve currency, but I digress.

The problem that we're facing now is that spending is a two-part process. Congress first authorizes the spending, then they authorize the Treasury to actually borrow the necessary funds to cover the deficit. Every few years (78 times since 1960), Treasury bumps into the debt ceiling. The debt ceiling is an arbitrary limit to the amount of debt that our country can take on. When we near the debt ceiling, each party begins playing a game of chicken to extract promises from the other side. They use the debt ceiling as a cudgel, when in reality both sides have spent egregiously and both sides have raised the debt ceiling in the recent past.

There's a real discussion to be had over how much debt we should carry as a country and how we should allocate our spending, but this isn't the time for it. Increasing the debt ceiling is necessary to fund the spending that Congress has already approved. The conversation regarding spending is one Congress should have prior to passing any spending.

So what is the worst case if we fail to raise the debt ceiling? A default is likely, as the Treasury would simply run out of money to make bond payments. This would have several knock on effects, but in short, it could drastically harm the Dollar's appeal as a reserve currency. Parts of the government would grind to a halt and those expecting payments from Social Security and other federal benefits would be left waiting. Going forward, our borrowing costs would rise as our credit-worthiness would drop. Overall, it's a pretty terrible outcome.

Here's why I don't think that's the likely option. It all comes down to preferences and constraints. Constraints guide behavior, while preferences influence behavior within those constraints. Preferences are often voiced the loudest, while constraints go unsaid. Within the debt ceiling debate, the constraint is the negative effect a default would have on the US economy, and the party that pushes us into default.

The preference of the Republican Party is to negotiate lower spending, and it's likely they will receive some token spending cuts during the negotiation process. That said, it's unlikely that they allow their preference to override their constraint. We all know that politicians want to stay in power above all else.

The wildcard here is the lack of unity in the Republican Party. House Republicans have a slim, five vote majority. Speaker Kevin McCarthy can't lose many votes and still have enough votes to pass. This lack of strength showed early when it took 15 votes to elect him Speaker of the House, and only after major concessions to the far right wing of the party. In a typical debt showdown, this would be an opportunity for the moderate wing to outflank the Democrats and get some concessions on spending. The worry here is that the far right of the party is driving the narrative and they haven't shown the ability to agree on much of anything. If Republicans want to take advantage of the current debt crisis, they need to find common ground and present a united front. My (small) worry is that the far right will derail a potential deal, to our detriment.

Since it's Derby week here in Louisville, I'll handicap the potential outcomes. First, the likelihood of reaching an agreement to raise the debt ceiling well ahead of X Day, the day we run out of money, is low. I'd put it at 10%, as both sides will continue to play chicken with the debt ceiling. The likelihood of an actual default is also low, about 15%. Finally, I expect we have a 75% chance of running right up to the line, but then finding enough common ground to raise the debt ceiling.

My big takeaway here is that you don't need to worry. The media will stir things up, as they always do, but the chances we don't raise the debt ceiling are low.